Brief Discussion and Application of Keynesian Theory

In this short section it isn't possible to highlight all the technical features of the theory which J.M. Keynes set out.  We will hit only on a few.  Keynesian theory is demand-side theory.  The main issue is: what governs consumer spending and investment spending?  The theory involves looking at the way consumer and investment spending and other spending behave, and how they come together to determine income and output in the economy.   The spending leads to an equilibrium level of income and output (measured by GDP).   In the formal model, the GDP is read off the lower axis of the graph.

Note: this discussion can easily be extended to include the other two major components of total spending, beyond consumption and investment, namely, government spending and Net Exports.  However, in the interest of simplicity, those extensions will not be considered here.

Consumer spending depends heavily on income, and the pattern of spending in relation to income is the "consumption function."   Keynes believed that when income increases people begin to devote a larger fraction of income to saving (can also be said: devote a smaller fraction of income to consumption).  Say, if a person's income is $10,000 then perhaps all will be spent, but at $100,000 perhaps 20% will be saved (80% spend).  This is thought to apply to consumers taken together:  as income rises the proportion saved increases.  All of this leads to figures called the marginal propensity to consume (MPC) and save (MPS).  These can be thought of as fractions or decimals.  The MPC is computed as the change in consumption divided by the change in income.  For the MPS you substitute saving for consumption.   To make the calculations, naturally, you must have some actual or hypothetical data about income, consumption, and saving.

The MPS is useful in computing yet another figure, called the multiplier.   The multiplier tells you how much GDP will increase when consumption or investment (or whatever) increases.  Without a lot of details, here's the essence.  Say the MPS is .2, meaning that for every additional dollar of income received by consumers, they save 20 cents and spend 80 cents. The multiplier will be 5, as calculated by this formula: 1/MPS.

What the "5" tells us is that if consumer or investment spending increases by, say, $10 billion, the GDP will increase by five times as much, or $50 billion.  You can see that saving behavior has a lot to do with what happens in the economy.  By the way, this point can be described graphically, as follows:  here the C+I line rises vertically by 10, and the new equilibrium point (intersection of C+I and the 45 degree line) is 50 more on the lower axis.

The tricky thing about this subject is we have to be careful about our meanings.  In the above paragraph we talk about an increase in consumer or investment spending.  This refers to an increase in spending which is caused by something other than an increase in income.  For example, with respect to consumption,  we are referring to an upward  shift of the consumption function, and not a movement along it.  This kind of upward shift would be caused by something like a change in consumer expectations (confidence).

1.  Assume that there are no government expenditures in Frodoland, and that the economy is closed (that is, no exports or imports), and that  there are no taxes or government transfer payments or undistributed corporate profits.  In 2004 suppose that firms want to invest $200 billion and that the consumption function is as follows:
 

Disposable Income	Consumption Expenditure
900	750
1000	800
1100	850
1200	900
1300	950
1400	1000

Using graph paper, create a set of axes as in the graph "A" below, and also one like "B".

Since these graphs may be difficult to read on the screen, the following information is being provided.
Graph A has "Consumption Expenditure" on the vertical axis and "Disposable Income" on the horizontal axis.
Graph B has "Intended Spending" on the vertical axis and "GDP" on the horizontal axis.
Both graphs have 500, 1000, and 1500 as the numerical labels on both the vertical and horizontal axes.

Now Plot the consumption function on graph A, along with the 45 degree line.
Next, plot the consumption plus investment line on graph B, along with the 45 degree line.
Use these graphs in the questions which follow (you don't have to show your work on the graphs):

1. Answer these:
a. Will GDP be at its equilibrium level if it equals $900 billion?  Why or why not?
b. Will GDP be at  its equilibrium level if it equals $1100?  Why or why not?
c. Will GDP be at its equilibrium level it it equals $1000 billion?  Why or why not?
d. What is the value of the multiplier?
e. If intended investment increases by $100 billion by how much will equilibrium GDP increase?
f. If the consumption function shifts upward by $100 billion, by how much will equilibrium GDP increase?
 

 2. Suppose that each of the following events occurred in 2004.  Taken by itself, would it increase the amount firms want to invest?
a. A major invention occurs which makes it possible to convert coal into gasoline cheaply.
b. A major recession occurs.
c. A giant earthquake destroys a great part of the capital located in California.
d. Interest rates fall by 2 percentage points.
e. Because of decreases in productivity, costs rise rapidly in the construction industry.
 

 Suppose that each of the following events occurred in 2004.  Taken by itself, would it shift the consumption function upward, downward, or have no effect?
a. The liquid assets held by consumers increase by $50 billion?
b. Disposable income goes up by $30 billion?
c. A substantial increase in population?
d. Consumer confidence in shattered by developments on Wall Street?